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Early Withdrawal Penalties – The Real Cost of Withdrawing Retirement Funds Early

When times are tough, making early withdrawals from your retirement funds can seem like a quick source of cash. It is. But it can be an extremely expensive source of quick cash. Many people don’t realize that making early retirement withdrawals can hit you four times at once!

When You Can Make Early Withdrawals from Retirement Accounts

According to the Pension Protection Act of 2006, you are allowed to make withdrawals from your 401(k) in certain circumstances. There are a few situations that the IRS will consider acceptable reasons to withdraw from your retirement account.

One of the most common reasons is for un-reimbursed medical costs for you or someone that depends on you. If you have fallen ill, or something tragic happened to your spouse or a kid, you can be left with a massive amount of hospital bills. If you don’t have the money to cover those expenses, then you can make a withdrawal from your 401(k).

Another circumstance you can withdraw from your account is if you’re responsible for paying for college tuitionor a related education cost for yourself, your spouse, or one of your kids. The average cost of a college degree is anywhere from $10,000 to $25,000 a year. For a lot of families, that college education can be a difficult bill to cover. If you find yourself facing expenses college bills, then you can legally dip into your 401(k) to get the money that you need.

Some of the other hardship withdrawal are funeral costs or some expenses for repairs for your home. There are plenty of expenses that you can’t plan for, like a death in your family or a tree falling on your home. You never know what’s going to happen tomorrow. If you find yourself responsible for a massive amount of debt and bills, then withdrawing money out of your 401(k) might be the only possible route that you have.

Before you do that, regardless of which of these scenarios you fall under, it’s important you understand all of the fees and penalties you’re going to face.

These Are The Real Costs of Withdrawing Retirement Funds Early!

Every year, I hear a lot of stories about people who make the withdraws from their 401(k), and it turned out to be the worst mistake of their life. Here is why it costs so much to make early retirement account withdrawals:

Taxes

The first thing that is going to get you is the taxes. Qualified retirement plans such as IRAs and 401(k) plans (and others) have some nice tax advantages. When you make an investment into a Traditional retirement plan such as a Traditional IRA or Traditional 401(k), the money is not taxed until you withdraw it. This is designed to allow you to invest more money upfront and give you years of tax free growth. When you withdraw that money early, you lose that tax advantage and must pay the taxes immediately.

Early Withdrawal Penalties

Early distributions from an IRA, 401(k), 403(b) or other qualified retirement plan are subject to a 10% early withdrawal penalty. That means not only are your withdrawals taxed, but an additional 10% is taken from the withdrawal to pay the penalty. Double-whammy!

Less Money for Future Growth

Compound interest is the most important thing you have working for your retirement. The more time that compound interest works in your favor, the more money you will have when you retire. Leaving your money in your retirement accounts means you will need to save and invest less money over your remaining working years. It’s better to get ahead now instead of trying to play catchup with your retirement savings when you are older.

Possible Market Losses

If your retirement account holdings have depreciated, not only will you have to pay taxes and early distribution penalties, but you may be paying them on less money than what you originally invested. Overall, the markets have not done very well the last year or so, and it is possible that some of your investments have lost money. Leaving the money in your investments gives them time to appreciate and not only regain their previous value, but hopefully appreciate beyond your original investment.

Exceptions

Withdrawing from your retirement account can seriously cost you. There are a few exceptions that you can meet that will let you bypass the taxes and fees. One of those is if you leave your employer after you turn 55, then you can be exempt for the penalties. This is not every case though.

Some of the other exemptions are permanent disability of if you have a ton of medical bills. If you have healthcare bills that are more than 7.5% of your adjusted gross income, then you might be able to withdraw from your retirement account without having to pay the penalties.

Taking on a Loan on your 401(k)

What some people don’t know is that they can take out a loan on their 401k. Depending on who much is in your 401k, you can secure a loan based on that money. These loans are not subjected to any of the taxes or penalties. You can make contributions to the plan while you’re paying back the loan. In most cases, you’ll be able to take out a loan that is around 50% of the total value of your account.

One of the main disadvantages of taking out a loan on your 401(k) is that if you were to leave before you paid back the loan, you would be responsible for paying back all of the remaining balance. Failure to repay the outstanding loan will result in immediate taxes and early withdrawal penalties, which can further compound an already bad situation. So tread carefully before taking a 401k loan.

On the flip side, there are some benefits to these plans. If you’re ever in need of money, then taking out a loan is going to be a much better idea versus withdrawing your money. These loans will give you access to money quickly, at a low interest rate, and they won’t appear on your credit score.

Should I Use My Retirement Accounts to Pay Off Debt?

You will likely be better off leaving your money in your retirement account unless you are in a very bad financial situation with crushing debt and no way to repay it. If at all possible, try to avoid withdrawing your retirement funds for short term needs. There may be other ways to get the funds you need, such as working overtime, taking a part time job, or raising funds by having a yard sale or selling unneeded items on Craigslist, eBay, or websites like Decluttr.

If you’re looking to make some extra money, there are dozens and dozens of different things that you can do to make money. In fact, there are plenty of ways that you can even make money while sitting on your couch. Things like selling on Etsy or doing survey panel websites will let you make some extra cash while you binge watch your favorite shows on Netflix.

Stay the Course

Everyone’s situation is different, which means that I can’t say that you should NEVER withdraw your retirement account early, but I would strongly advice against in 99% of cases. You should do whatever you can do avoid having to do that.

Your retirement is one of the most important things that you can plan for. You are working hard to live the retirement of your dream, but there are hundreds and hundreds of things that can go wrong and cause your plans to go off the tracks. It can be overwhelming and confusing trying to plan for your retirement and ensure that you’re taking all of the necessary steps.

If you have any questions about your 401k or other retirement components, please continue to look at the other articles on my site, or feel free to contact me with your concerns.

43 Comments

EmilyMay 8, 2008

I know so many people who have been slammed by making this mistake. It’s the number one reason I think everyone has to have a backup plan for job loss. It’s inevitably the route people choose who have poor money management skills and don’t have a savings account to cover expenses for income loss.Of course, once you pull the trigger and do the withdrawal, it’s a huge cycle because you can’t afford the tax penalty and on and on and then oooooh the debt I’ve seen people have to dig out of because of it.

When I studyied commercial law in college some time ago, I remembered vividly that retirement account balances of up to 1,000,000 cannot be taken away from you in the case of bankruptcy. So if you really are in cash crunch, do what PAtrick told you to do.. Or apply for a loan at Prosper if you don’t want to get into credit card debt..

One option if you absolutely have to have money is instead of withdrawing from your 401k, borrow from it. This assumes of course its for one of the IRS defined emergencies….not things like you mentioned (food, bills etc). In these kind of cases I think “extreme frugal” is the right course of action. When I got laid off Ramen soup with almost anything you can think of mixed in -10 for a dollar!

Yes withdrawals from a retirement account should be an absolute last resort. Like many financial mistakes the time to avoid this mistake is not the day you make the decision but your actions for years in advance. So you have a ready source of emergency funds, and other savings… to draw on in tough times…

I think you had it right. You do get taxed on the money twice when you take a loan from the retirement account.

When you take a loan from a tax advantaged retirement account, you repay the loan with after tax money. When you make normal withdrawals or are forced to take a required minimum distribution, the amount withdrawn is again taxed at your ordinary income tax rate.

So yes, the amount of the loan you took from the retirement account is eventually taxed twice.

I would not withdraw retirement funds for any but the most drastic situations. Just treat that money as unavailable. It is too easy to get in the habit of tapping that money and ruining retirement plans.

Asher, it’s tough to say without knowing your full tax situation. Basically, it will be a 10% penalty, then state and federal taxes at your tax rate. For more information you should contact a tax professional or the IRS.

I called to see what I needed to do, they said I could just leave it there and
not have to do anything. The next month I got a check from them and the taxes were taken out. I called and told them I had not asked for this and way I got this. They told me that I would have to take this up with the IRS and that they had given me the wrong information and they were sorry. But that they either could not or would not do anything else.

I put all of the money into a IRA but I still had $4,000 taken out and sent to the IRS. I don’t have enough money to make up the $4,000 that was sent to the IRS will I be penatlized on that $4K since I did not have the money to re-do the IRA? I don’t have the money the government does?

David, I recommend speaking with a tax professional, ASAP. You won’t have to pay early withdrawal penalties if the money is rolled into an IRA quickly enough. However, I’m not sure of the exact details of your case, so it’s best to speak with a professional. Best of luck!

My situation is, I may be forced to retire early, before 56. I am 50 years old and unable to touch my TSP till I am 591/2. This is because I am retiring before my MRA or 55. Wondering if there was any possible way to withdraw TSP money without paying the 10 percent penalty before I am 591/2.

Mike, There is not a way that I am aware of. The TSP has hardship withdrawal rules, but retirement is not listed as one of the reasons for making an early TSP withdrawal (and the early withdrawal penalty is still assessed). You can read more about it here: TSP Hardship Withdrawal Requirements.

We have gotten into huge credit card debt and i’m getting my hours cut almost in half. Together we make about $88,000 gross we live in iowa, what tax bracket will it put us in and what % will I have to pay for federal and Iowa taxes for early withdrawl on $50,000

Jim, I regret that I can’t give you a firm answer – it requires information I don’t have access to. I recommend visiting with a financial planner for more information and perhaps to recommend a plan to help you get current on your bills and get out of debt.

Hi We have recently gone through a BK and are losing our home to foreclosure. Rent in our area would be approximately 1800-2500 per month. We have an opportunity to purchase a home with the owner carrying back that would allow us a payment of $700 per month on a brand new home. We would have to withdraw $50,000 from my traditional IRA. Is this a smart thing to do? I know the disadvantages as far as taxes but it is an investment in our future to purchase this home.

Lori, it sounds like you have been through a lot of financial stress recently. Buying a home is not always an investment, and it can be a cause of financial stress. I recommend you speak with a professional money manager or debt counselor before making such a major financial decision.

Hi Ryan, I was working at an Ivy-league school for over 2 years, resigned the job recently and joined Grad school. Now I’m running into a financial situation, I need some money to pay my tuition. So I’m wondering about withdrawing from 2 of my 401k accounts(TIAA, Fidelity).

Can 10% early withdrawal fee can be waived, since this is for education purpose? And also what would be the long term consequences if any. I appreciate your help, thanks in advance.

Venki, I don’t believe the 10% early withdrawal penalty can be waived for making withdrawals from 401k plans if you use the money for tuition. However, it is waived if you make withdrawals from an IRA and use the money for qualified educational expenses. You will, however, be required to pay income tax on the withdrawals. Since you have already left your job, you can rollover both of your 401k plans into an IRA, then withdraw the amount you need to pay for tuition. Just keep in mind you will have to pay income taxes on your withdrawals, since you haven’t yet paid taxes on that income. Here are some instructions on how to Rollover a 401k into an IRA. Best of luck!

Hi Ryan, I think I may fall into the category where it makes more sense in the long-term to take a piece of my retirement to get out of debt. I have $7000 of credit card debt at 18% interest. With my income I can only afford to pay a little more than the minimum which will leave me paying it off for about 15 years with I think about $16,000 in interest, and leaves me with no emergency source of funds now. After a messy divorce and 2 years of unemployment, although I was able to qualify for a mortgage, a home equity line (which would be a more desirable way to fix this) is just out of my reach. If I take a $12,000 withdrawal from my IRA, I can immediately put aside enough money to cover the income tax on it and pay the penalty and still have enough to clear the credit card. What do you think?

Chris, in your situation, it might make sense. the key here is to make sure you do exactly what you plan to do – make the withdrawal, set aside the cash to pay the taxes and penalties, then pay off your debt. This will eliminate the 18% interest rate you are paying. There are two important follow up steps to make sure this works in your favor:

1. Change your habits to prevent debt from creeping back into your life. The first thing I would recommend after paying off your credit cards is to start an emergency fund. Many financial advisors recommend having several months of living expenses saved.

2. Begin making retirement fund contributions again, once you get your emergency fund in place.

These two steps will help you get your finances in order, give you a financial cushion, and help rebuild your investment portfolio. Again, the key is to follow through. Best of luck!

will i still be considered for the federal and state eic credit if worked but took out retirement 401k early? And if so, can they take out the tax penalty out of that? Will that money i got early affect how much i get for credit , if i didnt take it out, would be different?

I have 2 secured loans that r outstanding $6500.00. I have a 401k with my job that matches and a 401k that was rolled over from another job. I would like to take out a loan to pay off this debt. The debt is causing me sleepless night and I have been employed by my company for the last 25+ years. I would like to repay this money back into my 401ks within a 2yr period. I am 57 yrs of age and I plan to work until I am 70+(if my health allows).

Linda, it’s a good idea to look into the ramifications of taking a loan from 401k Plan and what can happen in the event you leave your job and how it will affect your investment growth. If you are OK with those risks and it helps you sleep better at night, then it may be a feasible option.

I will turn 65 next year and have just retired [at 64]. I received a two year severance package and won’t need to withdraw from my 403b for a couple of years. My question is: Should I withdraw enough funds from my 403b to pay off my house so that I won’t have to pay the loan interest on my house?

I’m 59 1/2 and considering cashing out my Roth IRA (free of penalties and tax repercussions) to pay off my car. My Roth is paying 3.5%….my car payment interest is 5%. I’m thinking of applying the $272.oo a month car payment to my condo payment………I owe 4 more years on the mortgage of my condo, and 2 1/2 years on my car. My thought is to eliminate debt as I head toward retirement. Should I eliminate debts at this age, or continue to pay monthly car and condo payments, (in hopes my job will last) and save my Roth IRA for retirement?

I think the answer to your questions should be decided by your long term plans, including when you wish to retire, whether or not you have additional income streams for retirement (such as a 401k plan, pension, spouse’s income, other investments, etc.). Right now I think the best thing to do is take a long look at retirement planning and your retirement goals, then make your decisions based on your long term goals. There are a lot of factors which go into this decision so I encourage you to visit with a finical planner for a one on one meeting so he can go over your entire financial situation and help you create a plan for retirement.

I have been off work since Sept. due to Medical Illness & was given the OK to return to work this month. I have exceeded my FMLA time & have to work w/HR until April 8 to find another postion. If nothing is found I will be terminated. Unfortunatley I do not have money put aside in the event of job loss or any other kind of emergency. In about 3 weeks I will truely be penniless. Until the time that unemployemnt kicks in (my job has a tendency to drag that out for about 1-2 yrs) I have no other source of income/way of paying my bills. My only resort IS to take the money from my 401k plan & live off of that until my unemployment starts. Any advise on how to procede & handle this money once I get it. I now see the value of having @ least a years worth of monthy/yearly expenses set aside. Lesson learned, now how to be smart & successfuly move forward from here?

Here is my situation, the company I worked for that i have my Pension plan in was bought out by another company. I have less than $2000 in that plan. I have come in some hardship and need to get some bills payed. I make min wage and could really use that money right now. I’m under 59 so I understand there’s a 10% tax that will be taken out if I withdraw early, but what other taxes will be taken out? I don’t get much back at tax time, but how will that affect me at the end of the year as far as having to pay taxes instead of getting a small refund?

I am no longer working for a school district which means I have TRS sitting in my TRS account. Since then I am working at another company where I contribute into a 401K. I have other investments accounts, Roth IRA’s, etc. My questions or dilemma is, I am wanting to move and thought about using the TRS funds from both me and my wife to pay for a down payment. I know I will be hit on taxes as income, but is it usually the 10% early fee that I would be hit with? I have been reading and everybody says, no no no, don’t do it, last resort, etc. which is helpful information, but I have other means of income, retirement plans outside of TRS, and I am looking at it as we worked for that company for 10 years, now I want to use what we earned with TRS for a chance to move into a better home/area. Thoughts? Thanks

Jon, it’s usually a bad idea to make early withdrawals from a retirement account because you will pay both the 10% early withdrawal fee, and interest on the income. If you are looking at buying a home, and you are a first time home buyer, you may be eligible to make a $10,000 withdrawal from your Roth IRA and avoid any penalties or fees. This still isn’t always a good idea, since you lose out on retirement income and the growth you would have had. But it is generally better than paying a penalty and income tax on withdrawals from a different retirement fund. It would be a good idea to meet with a financial planner to see what your options are and how much this will cost you before you take action. Paying a small amount of money for an hour long consultation could save you tens of thousands of dollars (or more) in the long run).

Would it be bad to pull 1,000 to 2,000 out of an IRA? I’m 24 and due to a big move we have slipped a little behind. I make 38,000 a year I don’t think this will change my tax bracket but I don’t want to get behind on payments.

It wouldn’t be the worst financial move ever if you pull a small amount of money from a retirement account. But it’s not ideal. If you pull the funds from a Traditional IRA you will have to early withdrawal fees of 10%, plus any taxes on the income. So that $1,000 withdrawal may only be worth $750 at the end of the day (15% tax bracket), not to mention the lost earnings. A $2,000 withdrawal would only get you about $1,600 – again, not counting the lost earnings. If you withdraw from a Roth IRA, then you may be able to withdraw from your contributions without paying any early withdrawal fees or taxes, but be sure to verify the rules before making any Roth IRA withdrawals, because there may be other factors that affect the taxes or early withdrawal penalties. When in doubt, consult with a financial planner or tax professional.

As far as other ways to generate the cash – avoid any high cost loans, such as title loans or pay day loans. Credit cards can actually be a decent way to pay for large expenses if you have a low interest rate and you are certain you can pay off the loan within a few weeks or months. Otherwise, leave the credit cards alone. Other options include selling things you don’t need or use any more, taking on part time work, etc. Best of luck with your decision.

I terminated from my company and took a cash withdraw from my esop account. I had 25% taken off the total. I marked on the form that I wanted 10% early withdraw fee and to have state and federal taxes taken out immediately. I am confused, isn’t state (ia) 5% and federal 20% and early withdraw 10%? That should have been 35%. I am afraid I will still have to pay another 10%. The total was 196,000 and when i received the check it was 147,000. Will I owe more???

I’ll be 62 in two months and will claim social security benefits and also retire from government after 36 years. I plan to leave my TSP until the minimum withdrawal age. That is about 8 years from now. I’ll have annuity, ss, and mil service retirement checks; my wife already have 2 checks. I’m hoping that congress will pass the law to allow for more TSP withdrawal options. My questions, is it better to leave the account invested in different funds or move them all in ‘G’.

Rombol, it sounds like you and your wife will have many options during retirement! The minimum withdrawal age to avoid penalties is age 59½. So you can make withdrawals at any time. I believe you are referring to the Required Minimum Distributions, or RMDs, which begin at age 70½.

There isn’t enough information to say whether you should have your investments in the G Fund, or a variety of other investments. It comes down to your investment goals, timeline, and risk tolerance. If your annuities, military retirement pay, and Social Security benefits cover all your spending needs, then you may be able to take more risk, since you will have so much stable cash flow. On the other hand, you may feel as though you have already won the game, and don’t need to take on any additional risk. And you could decide on a balanced portfolio. The bottom line is that we don’t have enough information here to provide an answer, and even if we had more information, this is a decision that you will need to make based on the criteria listed above (goals, timeline, and risk tolerance).

I recommend visiting with a fee only financial advisor (fee only meaning they will charge a flat fee for advice, and not try to get you to trade in your TSP investments for an annuity or other commission-based investment – you don’t need those). If you are more of a DIY investor, then I recommend visiting the forums at Bogleheads.org, which focuses on low-cost investing, following the principles made popular by Vanguard founder Jack Bogle. Best wishes!

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